Summary
As companies look to reduce IT spending as one response to the economic slowdown, they risk throwing the baby out with the bathwater – cutting back or eliminating spending on initiatives that have strategic value for the company. Our benchmark research has found that few companies are able to accurately identify how individual business units and their activities drive IT spending; without this clarity, cuts in this area tend to be across the board rather than prioritized. Consequently, in seeking to help, IT departments can fail to deliver what both the organization and their line-of-business customers really want and need. Lacking strategic clarity, they scrap important new initiatives in favor of keeping creaky older systems that few would pay for if they had the choice. To maintain and improve their positioning vis-a-vis the economy and their markets, corporations must have the tools to be able to determine what business value drives IT spending and use them in allocating IT dollars. They also must allow business unit managers greater freedom to choose which IT services they consume. Ventana Research believes that combined, the two will enable corporations to make more effective use of the IT dollars they spend. Because they are at the center of the allocation process, finance departments must drive the development of a more intelligent costing process and they must use the right tools to manage allocations.
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The IT department is a cost center, which means its operating costs must be passed onto other parts of the business. Our research finds that few companies are doing this well. Some of these costs (such as named-user licenses or third-party maintenance on applications used by a single business unit) are obvious and can be allocated directly to a business unit. Others are more difficult to assess and therefore often are allocated according to some indirect formula such as headcount or area occupied. Unfortunately, although there may be some logic to these metrics, they do not give business managers a clear indication of the true IT costs they are incurring nor do they enable them to act effectively to optimize their IT spending.
Doing so requires greater transparency in the relationship between business processes and IT spending and more granular control over IT consumption at the business unit level. There is a basic economic logic behind this assertion. In contrast to centrally planned economies, free markets are able to achieve greater efficiency and higher consumer satisfaction because the market pricing mechanism more accurately reflects real costs and true demand. Unfortunately, this basic principle is absent in how corporations deal with managing their information technology departments. Rather than being able to choose item-by-item, business units must buy a package of IT services, usually configured without much input from them. Our research finds that only a few companies do a good job when it comes to understanding how business units and their activities cause IT departments to incur expense. Fewer than one-third of the corporations with more than 1,000 employees that we benchmarked charge back IT spending based on actual costs incurred, as documented in time sheets or invoices. Only one-fourth have a formal process for eliminating or upgrading applications that are under-used or otherwise do not provide value. Just one-fourth understand in detail the costs of their business applications and projects. Only 20 percent of those who are in a position to know say that they pay too much for vendor-supplied maintenance and that this is a problem, half say they pay too much but it isn’t a problem! (Apparently, the issue is so deep-seeded that people have become inured to it.)
To achieve greater transparency, organizations must use techniques that focus on the business activities that drive cost and allocate IT department expenditures accordingly. Some form of activity-based costing (ABC) is necessary to ensure that IT resources are charged back intelligently. This isn’t new advice – it actually goes back to the 1990s – yet relatively few corporations have taken it. Along with this measurement process, managers need the capability to evaluate the services they are getting from the IT department and to stop using them if they are not valuable enough. Often, IT departments feel challenged when line-of-business units have greater direct control over what they are getting from their IT department, but our benchmark research finds this apprehension is misplaced: Companies that have greater visibility into how they are spending their IT budget and that manage IT spending processes more carefully consistently rated their spending effectiveness higher, grew their IT budget faster and spent a higher percentage of it on innovation rather than keeping the lights on.
To be sure, a completely free market in IT services is not advisable; some parameters need to be set. For example, some IT overhead benefits the company as a whole over time and should be viewed as essential services. The cost of providing these services should be apportioned as a “tax” on all parts of the business, much as one pays for a police or fire department even if it isn’t used in a particular year. (However, if these services represent more than one-quarter of IT spending, those in charge must be able to defend their definition of “essential.”) Other elements of IT department spending may not be optional for strategic reasons. In still other cases, business units may share a fixed-cost resource; when one or more drop out, it will drive up the cost to the remaining users, perhaps forcing them to drop this resource as well. There must be a process for mediating the impact of these actions – phase-in/phase-out credits and charges, for example. Moreover, a company’s charge-back process should be flexible enough to enable mediation of disagreements without being too complicated.
Assessment
If more than one-third of your company’s IT spending is allocated by some formula rather than using actual consumption-based metrics, your company has a problem. The same is true if business unit managers have little or no control over which services they obtain from IT. To make your IT spending more effective, your company should move quickly to address either or both. Doing so requires the right processes and tools (in particular, the right costing software) to implement and support change. Because of its involvement with cost accounting and allocations, we recommend the finance organization take the lead in implementing the change in the cost measurement and allocation systems. Ventana Research recommends that defining the rules that give business units greater control over the IT services they acquire be handled by a group headed collaboratively by the CEO/COO, CIO and CFO. Organizations will find the result is likely to be a leaner, more effective organization, one where IT spending is calibrated to deliver maximum business benefit.
About the Author
Rob heads up the Financial Performance Management (FPM) practice, focusing on the intersection of information technology and the finance organization. The FPM research agenda includes the application of IT to financial process optimization and collaborative systems; adaptive control and analytics; and advanced budgeting and planning. Rob has been a technology analyst for over 20 years. Prior to joining Ventana Research he was an equity research analyst specializing in enterprise software at Primary Research Partners , Senior Vice President at First Albany Corporation (an investment banking and institutional brokerage firm with a strategic partnership with META Group), a securities analyst with Drexel Burnham and Morgan Stanley, and a consultant with McKinsey and Company. Rob was an Institutional Investor All-American Team member and on the Wall Street Journal All-Star list. Rob earned his BA in Economics/Finance at Hampshire College, an MBA in Finance/Accounting at Columbia University, and is a CFA charter holder. Rob can be contacted at robert.kugel@ventanaresearch.com.
